Monday, 8 October 2012

DSGE critics and future directions for macro

Microfounded macromodels, aka DSGE models, hold a dominant
position in academic macro, and their influence in central banks is increasing.
(The Bank of England’s core model is DSGE, but the approach has not yet quite achieved
a similar dominance in the Fed or elsewhere.) At the risk of gross
oversimplification, you can class the critics of this situation into two
groups: the reformers and revolutionaries. The reformers (like myself) see DSGE
analysis as always forming a central part of macro, but want greater diversity,
with in particular more analysis using time series econometrics. The
revolutionaries want to confine DSGE analysis to a much more minor role, if not
the bin.

In a sense debate between these critics is a bit pointless.
We are standing on the same train platform, agreed on the direction of travel,
but at the moment the train shows no sign of moving. There is a danger that we
spend too much time arguing about when the train should stop, and not thinking
enough about how to get it going in the first place. Nevertheless I think it is
worth having the debate, if only because of tactics. Those DSGE modellers who
are sympathetic to reform can easily become defenders of the status quo in the
face of more extreme attacks.

So let me give one argument for reform rather than
revolution that I have only made implicitly before. When I studied macro and
then began working as a macroeconomist, mainstream macro was divided into schools
of thought. In an environment where both inflation and unemployment were
high, you had monetarists saying that you just needed to control the money
supply, some Keynesians arguing that we should focus on unemployment because it
had nothing to do with inflation, and New Classicals saying unemployment was
not even a problem. Each school had its models, and each claimed empirical
backing. Econometric analysis was not strong enough to discriminate between
schools. Different schools tended to talk across each other, and anyone trying
to look for common ground or ultimate sources of disagreement had a hard time,
and ended up writing lists. For a policymaker or student it must have seemed like a
nightmare, and no wonder many chose which school to follow based on its
ideological associations.

In my view microfoundations brought some order to this chaos
(see this
from here).
Now for heterodox economists who think the microfoundation approach is
fundamentally flawed, this is a problem: we are looking at alternatives through
the wrong lens. But for those who think that, for at least some problems, basic
micro reasoning is a good place to start, microfoundations provided a common
language with which to discuss and appreciate different points of view. Note
that this is not an argument for complete synthesis, but just a shared
language.

As Diane Coyle noted
about the conference we both recently attended, the UK’s social science funding
agency (the ESRC) is considering what kind of research in macro is needed
post crisis, and therefore what funding initiatives might be appropriate. Here
I want to present a cautionary tale. Macro is dominated by US economists of
course, but one area where the UK was strong was in the building and empirical
evaluation of econometric macromodels. This reflected strength in time series
economics (David Hendry, Hashem Pesaran,
Andrew
Harvey to name just three), but was embodied in the ESRC
Macroeconomic Modelling Bureau, directed by Ken
Wallis from 1983 to 1999. However with the intellectual tide moving ever
more strongly in favour of calibrated DSGE models, macro papers by those
involved with this area were not hitting the top journals. Partly as a result,
the ESRC (which really means the academic and other macroeconomists advising
the ESRC) decided to discontinue funding for the centre.[1]

I thought that was a huge mistake at the time, and that
conviction has been reinforced by recent events.[2]
What the Bureau did was bring modellers from policy institutions and academics together
around the concrete endeavour of comparing the models used by those
institutions. At the very least, modellers became aware of alternative
perspectives, and models used by policymakers were subject to critique.
This has now been lost. The moral I draw
from this mistake is that it is dangerous to sacrifice strengths to fashion.
The UK retains strengths in time series macro: one of the strongest papers at
the conference was presented by John Muelbauer,
whose work on financial liberalisation and consumption I have discussed
before. However the UK also has a number of economists producing strong work in
the DSGE tradition, and this should also be encouraged. What the UK really
lacks (and the key message from the report Diane cites)
is academic macroeconomists, and the reason for that is for another post.

[1] The Centre was co-funded by the Treasury and the Bank of England, and the absence of strong support from these institutions may also have been important in this decision. Both institutions were of course subject to the same intellectual tide, and may have had mixed feelings about being open to external critique.[2]Unfortunately this was not the first time lack of support from the ESRC killed
off a very innovative and productive macro research team. Many of the issues involved
in optimal policy analysis in rational expectations models were first
investigated by David
Currie and Paul Levine in the 1980s, but funding support for this team was
not renewed by the academics advising the ESRC.

8 comments:

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But for those who think that, for at least some problems, basic micro reasoning is a good place to start, microfoundations provided a common language with which to discuss and appreciate different points of view

It's a common language, but as such, it's more like Scholastic Latin than Swahili - it lets a particular class of high-status professionals talk to each other about a particular set of problems in their own area of interest. For example, emphasis on microfoundations pretty much killed institutional economics and the whole tradition running from Veblen to Galbraith.

At the moment, probably the biggest and most interesting question in macroeconomics is whether and on what terms Spain will enter an IMF/ESM program. That question is clearly tied up with the perceived long term political consequences of doing so for Rajoy and the Partido Popular. Obviously one could create a microfounded model whereby rational voters working with limited information decided to severely penalise governing parties who gave up sovereignty, and then combine it with a microfounded public-choice model, but it would be pretty clear that this was an ad hoc response; you wouldn't have it hanging around in the literature unless you had an independent reason to believe it might come in useful. So a literature based wholly on microfounded approaches is going to be doomed to always be fighting the last war. The real scandal of macroeconomics isn't anything to do with modelling - it's that so many macroeconomists didn't know what a CDO was until they read it in the Financial Times.

My point is that it isn't just in empirical work that DSGE needs to be reformed and supplemented; there does need to be space for views that aren't based on a view of the economy under which everything can be reduced to choice theory. I would guess that this is sort of what you have in mind by saying that DSGE needs to be "a central part" rather than "the central part" of macroeconomics, but this is where a sociological approach to the profession itself is important. The microfoundations approach, as you say, is still dominant. They have a position at the top of the profession with a massive share of the top journal slots. They're not going to give that up or share it with other schools of thought willingly. So if you're a reformer in terms of ultimate aims, you need to be a revolutionary in terms of immediate tactics.

1. I would strongly supports any efforts in econometrics (statistics). At the end of the day, physics is a huge number of statistical links before any theory can be built. The Higgs boson is not a particle in the Standard Model- it needs the propability of 0.999999 and five standard deviations to be "found". Without an elaborated statistical model one can not declare the Higgs boson as found. A similar statistical approach is applicable to any theory.

2. Both macro or microeconomics have to follow up all general prescriptions of metrology. When a researcher from hard sciences starts to dig into economic time series the first impression is that they all garbage. All macro time series I have ever touched (GDP, GDP defaltor, CPI, umeployment, labor force, productivity, population characteristics) have a big flag "not time compatibale". This kills any reasonable econometric approach by default. The first step has to be the preparation of a set of time compatible time series.

3. In the history of physics, macrofeatures (e.g. gas laws or photo effect) were usually precursors of microfoundations. When some phenomenon has a consistent (in time and space) behaviour one may try to explain it using a (short or far-field) coordinated (collective) behaviour of constituent parts. At this stage, the link between micro and macro economics looks like "garbage in - garbage out".

Ivan Kitov is correct: metrology is the key. Gary Gorton made a similar point: "Go back to macroeconomics. Macroeconomics as a paradigm in large part is determined by what is measured. If I told you that I had a 30-year panel data set of firms by sector and I had the deltas of the change in value with respect to certain systemic risks and idiosyncratic risks, people would calibrate models to measures of risk, right?

The way models are built, and the way people think, is determined in large part by what we measure. It’s determined by Kuznets, basically. So it’s hard to even imagine how you’re going to build models if we don’t measure things that are more directly associated with what we would like to know."

Somewhat vainly, I like to imagine that this post is directed at me ( among many others many of whom have made contributions which dwarf mine ). I am going to try to reply without being rude (there's a first time for everything).

I will invent a hypothetical possible alternate Simon Wren-Lewis (hence ASWL) with whom I agree. Not claiming to read minds, I won't guess if this fantasy figure is in any way similar to Simon Wren-Lewis. ASWL thinks that the DSGE school dominates the field (hence the alernative is called heterodoxy) and so to suggest tossing DSGE models in the bin is to become irrelevant. The proper rhetorical strategy for reducing the dominance is to argue for reform not revolution, to argue for diversity and not to dismiss the vast bulk of research in recent decades as totally unsatisfactory etc.

I note that the hypothetical ASWL would feel no need to address the relationship between recent research in Macro-economics and the data. Even in the hypothetical case that it were similar to that which would one expect for a fundamentally misguided research program, the power within the profession would make it unwise to consider that this might be possible.

Someone with a higher opinion of economists than I or the purely hypothetical ASWL have might assume that the best approach to the common quest for knowledge is frank discussion in which data are considered when evaluating the promise of research programs. But since the academic debate has some effect on the very important policy debate, potentially influential people should not sacrifice their potential influence by expressing frank opinions.

Again I am not even speculating about the relationship between ASWL and Simon Wren-Lewis.

Why not use agent-based modelling (ABM)? They're a great alternative to DSGE models, without compromising microfoundations. The Economist had a good article about ABMs: http://www.economist.com/node/16636121

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